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For Nick Sheridan, manager of the £28.4m New Star European Value fund, how to outperform is no secret.

“Every year for the last 15 years, Investor’s Chronicle has published a table of the top five or 10 UK stocks that match Benjamin Graham’s criteria of stock selection. Virtually every year since publication, those stocks have outperformed the market in that year. But to my knowledge, no one has taken any notice and tried to run a fund that way. Why is that?” he asks.

Mr Sheridan suggests fund managers like a bit of mystique. “It’s human nature to turn around and say it’s not that easy.”

Since his commonsense approach was adopted in July 2004, the fund has indeed outperformed in the long term. Over three years to 26 May, it delivered cumulative returns of 70.5 per cent, compared with a sector average of 60 per cent, which places it in the top quartile. The one-year record is less attractive: a loss of 2.3 per cent, against a sector mean fall of 0.5 per cent.

Mr Sheridan selects stocks purely on the basis of financial data. “I don’t spend any time meeting company management or going to results presentations. The only information that goes into the decision making is publicly available,” he explains.

The process he has developed revolves around four basic valuation metrics. The first is the price-to-book ratio, which shows the company’s net asset value relative to its stock price, or, simply put, the amount of money stockholders would receive if the company were liquidated.

“The balance sheet is the surest measure of value. It’s a big number so it gives you a margin of safety. If management are unable to raise the rate of return on the existing assets, it may attract predatory attention. So if all else fails, the company may be broken up to realise the asset value,” he says.

The second key input is current earnings. Mr Sheridan prefers to think in terms of earnings yield, measured as earnings per share divided by the share price, rather than the more common price to earnings ratio. An earnings yield of 10 per cent would suggest the company earned $10 (£5.10) for every $100 invested. Mr Sheridan looks for a high earnings yield in the expectation that it will sooner or later lead to a re-evaluation of the underlying stock price.

The third indicator is dividend yield. “Dividends are what allow you to sleep at night,” he says. “They’re a sure return because they go in your back pocket – the company can’t take them away from you.” He points out that to meet a return target of 8 per cent, a stock with a dividend yield of 5 per cent only needs to grow at 3 per cent.

This makes Mr Sheridan very wary of the fourth measure of company value – growth. “If you assume inflation is 2.5-3 per cent, a company with no dividend yield has to grow at 5-6 per cent in perpetuity to justify your 8 per cent return. That is very difficult. High growth rates will attract competition, unless you’ve got strong barriers to entry – and not many people have. Every study says barriers to entry disappear within 18 months, which dissipates returns.

“If you’re lucky, you may find one or two growth stocks over your whole life. You can’t buy a whole basket. It’s against the laws of probability. I rate growth very low down in my calculation of intrinsic value,” he concludes.

Instead, Mr Sheridan invests where the laws of probability suggest returns are concentrated – at the nexus of these four measures of value. “If you were to buy a basket of stocks on price to book, then the basket would, over time, outperform the market. Similarly if you took earnings yield or dividend yield, the basket would outperform. This is based on a study from 1996-2007 by JPMorgan, but you can get exactly the same information from UBS or HSBC,” he asserts.

A philosophy focused on probability theory lends itself to a quantitative approach. Sure enough, the fundamental analysis for the New Star European Value fund is performed by a computer system called FactSet, which screens the market according to Mr Sheridan’s weightings of the key financial data and produces a league table of best stocks.

Mr Sheridan then considers the results. He might discard a stock for two reasons. The first is a qualitative reality check. “I go away and read brokers’ notes and make sure what’s there makes sense. If the figures don’t make sense to me, I won’t hold the stock,” he says.

The second reason would be an excessive sector overweight. “I’m sector-aware but not sector-constrained”, he explains. “If banks are 25 per cent of the European market, I wouldn’t go beyond 40 per cent. But for a smaller sector which is only 2 per cent of the index, I’ll happily go up to 5 per cent.”

Except for these two checks, the fund is run on an entirely quantitative basis. Does it, therefore, run itself? Mr Sheridan’s answer is surprising – the fund may not require his judgement day in day out, but it does require his conviction.

“You’ve got to believe that these four criteria are what will allow you to identify opportunities in the market. Otherwise, when you underperform – and there are period of underperformance with any method – you will change approach. That’s why none of these funds run themselves.”